QUESTIONS RED-FLAGS / NOTES YOUR OBSERVATIONS FROM ANNUAL REPORT

1 WHAT IS THE CORE BUSINESS

1.1 Is there a clearly defined Mission Statement or Strategic business direction?
1.2 How does the company actually make money? If, after reviewing the company profile and introductory pages
of the annual report, you remain unclear on how the company
Does it sell physical products (e.g. manufacturing) or services (e.g. hospital, makes money, you are best advised to look at another.
1.2.a
school)?
Suggestion: Pick companies in industries you are familiar.
Can you clearly define the product or service category and customer profile, i.e.
1.2.b
geography, demographic? Note: If the company is a conglomerate (i.e., has multiple
What resources (i.e. staff, R&D, investments) must it deploy to satisfy its unrelated lines of business) concentrate on the key divisions.
1.2.c
customers?

2 IS MANAGEMENT STAYING FOCUSSED

2.1 What are the management’s stated plans to take the business forward?
2.1.a Expanding capacity? Question investments or acquisitions in areas which do not
facilitate 2.1.a, 2.1.b, 2.1.c, or 2.1.d, e.g. a manufacturing firm
2.1.b Rationalizing underperforming areas? buying land for property development.
2.1.c Introducing new products / services to existing customers?
Question if stated plans are unclear, or do not take the
Investing to raise margins (e.g. new product features, service add-ons) via R&D, company forward, or do not make sense to you in light of
2.1.d
marketing, etc? what you know.
2.2 Any acquisitions to facilitate 2.1.a, 2.1.c or 2.1.d?

3 ARE RISKS BEING ADDRESSED

3.1 What risks have management highlighted?
Be vigilant on risks that have been highlighted.
3.2 How are these risks being addressed?
Beware of management who fail to mitigate risks. If
Has management added to the risks, e.g. more than doubling its size via
3.3 information on risk mitigation is insufficient, query.
acquisitions? Can this be effectively managed?

4 IS MANAGEMENT CONSISTENT
4.1 Are plans discussed in the past still on-track?
If past plans are no longer discussed, query. If risks
4.2 Are risks foreseen in the past under control? highlighted in the past are no longer addressed, query. If
change in tone does not make sense, query.
4.3 Is there any change to overall tone? More optimistic or pessimistic?

5 CORPORATE GOVERNANCE DISCLOSURES

Companies must highlight where they do not comply with the IndAS, MCA and
5.1
regulatory guidelines. Review all highlighted areas.
Review Independent directors who should be at least one third of board
5.2
composition. Are they independent?

6 FINANCIAL STATEMENTS
 Did Net profit rise or fall due to change in: We always like to see improvements in sales and margins at
a. Sales? all levels. However, the key is to assess sustainability.
b. Gross margin?
6.1 Red flags would be:
c. Operating margin?
d. Interest expense, taxes? - steadily declining margins;
e. Non-recurring items? - dependency on non-recurring gains.

If cash-cycle rises, then inventory and receivables might be

6.2 Is cash-cycle rising or falling? Why? piling up too fast. A small red flag.
Is operating cash flow sound? Fast growing companies typically register negative Operating
6.3 a. Is inventory rising much faster than COGS? Cash Flow (OCFs). Otherwise, negative OCFs are a red flag.
b. Are receivables rising faster than sales? Where has the cash been used? Query.
6.4 Is Gearing too high? e.g. Net Gearing > 50% Financial leverage levels are industry specific, and they are
best benchmarked against industry peers. Regardless, high
6.5 short term debt levels vs. cash flow are generally considered
Is Debt repayable within 1 year very close to Net OCF for the firm? risky.
6.6 Is ROE improving or declining? Rising earnings with steadily declining ROEs are a red flag.
Changes to accounting policy can distort earnings. Beware of
6.7 Review changes to accounting policy, e.g. depreciation and R&D capitalization. changes that bring forward revenue or delay expense
recognition. Query if reasons are not clear.

7 OTHER AREAS
Assess the segmental breakdown of sales, profitability, assets & capital
expenditurea.
a) Is YoY change in sales and earnings by geography in synchrony with
economic conditions for those regions? Weakness in some segments might be offset by gains in
7.1 b) Do capital expenditure figures make sense? others. This breakdown can sometimes help identify stability
c) For banks, note the loans growth by segment. Is the bank taking sensible risk and non-recurring boosts.
vs. current economic condition?
d) For real estate, note capital expenditure by geography. Are they expanding
exposure sensibly?
Is there a stated dividend policy with a specific Dividend Payout? Is Actual
Dividend Payout steady, rising or falling? Question when companies cut dividend payouts.
7.2
Note that Dividend Payouts can range from 0% (typical of high growth firms) to Be wary of companies which accumulate cash on their
100% (very stable cash cows). Companies expecting modest 5-15% annual balance sheet with no clear investment plans.
growth can theoretically afford 20% to 40% dividend payouts.
7.3 Is the cash really there? i.e. Reconcile cash level to interest income If interest yield is too low vs. available interest rates for an
7.4 Are cash holdings excessive vs. stated investment plans? extended period, be wary

Is the company doing what they say? Which segments are seeing capital If the items on the balance sheet (asset item) or in the
7.5
employed/ total assets rising? segmental breakdown do not reconcile with the answer to Q3,
7.6 Which asset items on the balance sheet are rising or falling? be wary.

7.7 Did independent auditors give a clean bill of health? Beware of qualifications and emphasis of matter by auditors.